Fiscal Policy

When the economy begins to suffer from serious recession or inflation, politicians will almost always
intervene to try to improve the situation. Their interventions may or not be good economicsoften
they're not!but you can hardly blame the politicians for trying. Nobody wants to go down in history
like Herbert Hoover, the president who became a widely hated figure for failing to use the
government aggressively enough to try to end the Great Depression.
Politicians hoping to improve economic conditions have two main tools at their disposal. Fortunately
for them (and thus for the rest of us), the basic principles behind them are pretty simple. The core
thinking is that inflation and recession are opposites of one another. During periods of recession
there is not enough money circulating in the economy. During periods of inflation, there is too much.
So the answer to these problems is to either put money in or take money out of the economy.
At this point, economists begin to disagree over who should do the putting in or taking out, and
which means should be used to do so. Some favor fiscal policyadjusting taxes and government
spending. But most prefer monetary policyadjusting interest rates and reserve requirements, and
buying or selling bonds.
Fiscal policy is set by the president and Congress; they create the tax system and they decide how
the government should spend its money each year. The basic premises behind much of
contemporary fiscal policy were introduced by British economist John Maynard Keynes during the
Great Depression. Keynes argued, contrary to conventional thinking, that the market and the
economy could not regulate itself. During periods of recession, consumers hold on to their money
rather than spending it. Businesses were similarly afraid to expand operations and hire more
workers. Therefore, the government needed to jump-start the economy by injecting some money into
it. The tools for doing so were tax rates and government spending. By lowering taxes people had
money to spend; they could buy cars and appliances, or convert their garage into a game room. All
of this put people to work stimulating even more spending and job growth. By increasing government
spending, the government put money directly into the economy. Building a dam, extending
unemployment benefits, or hiring more teachers also put money into circulation and, according to
Keynesian fiscal theory, stimulated economic growth.

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Keynes argued that during periods of recession aggregate demand (AD)the total demand of
consumers, businesses, and government at various price levelsneeded to be stimulated through
government action. Through tax cuts and increased government spending, aggregate demand (AD1)
would be increased (AD2).
Of course, it gets more complicated than this. For starters, policymakers now debate whose taxes
should be cut during periods of recession. Traditional Keynesian fiscal policy emphasizes putting
money into the hands of middle and lower-class consumers, thereby stimulating the demand side
of the economy. Others argue that more permanent growth is achieved by cutting business and
corporate taxes, and by reducing capital gains taxes and personal income tax rates for wealthier
taxpayers. According to these supply-side theorists, the money saved through these sorts of tax
cuts will be reinvested in new businesses and large-scale expansion, thus generating more jobs.
Regardless of whose taxes you cut, however, this course of action may lead to government budget
deficits--that is, government spending may exceed government income. In response, some argue
that short-term deficits are acceptable since once the economy starts to grow, tax revenues will
increase. Others argue that deficits saddle future generations with debt and lead to high interest
rates, crippling future growth.
Fiscal Policy Options
To Fight Recession:

Reduce taxes
Increase government spending

To Fight Inflation:

Increase taxes
Reduce government spending

Why It Matters Today

This one's easy: looked at the news lately?
Just about everybody wants us to get out of this recession, to restore robust economic growth.
But what's the best way to do that? Keep the government out of things and let the economy run its
course? Or take deliberate government actions to stimulate the economy?
If you want some kind of stimulus, should it come in the form of tax cuts (and if so, for whom)? Or
should it take the form of increased government spending?